Educational Articles

Industry Analysis: Industries at Extreme Valuations

Marek Mscichowski
| April 10, 2014

With the stock market now generally at or near all-time highs, it may be helpful to investors to look at some of the industries represented in the The Value Line Investment Survey that are currently trading at extreme valuations, on a price-to-earnings basis.

Technology oriented stocks in a variety of industries have some of the highest valuations in the stock market. As a result, the tech-heavy NASDAQ, recently hit a decade-long high.

More specifically, stocks in our e-commerce Industry are some of the most expensive out there. NetSuite (N), for one, has no record of earnings, but is valued at over $8 billion. Sales in 2013 surpassed $400 million. Similarly, software stocks like Informatica (INFA) and RackspaceHosting (RAX) are pricey, with each trading at more than 50 times earnings. Both companies are investing heavily in R&D, and their prices reflect much speculation on future earnings potential. How these situations pan out will be seen over the long term.

Biotechnology stocks also have relatively high P/E ratios. Gilead Sciences (GILD) is one example. The company is valued at over $100 billion and seems only suited for the most risk-tolerant investors. The P/E ratio is about 40. The equity’s multiple has increased considerably in recent years, with the stock price on an almost parabolic ascent over the past two years.

Internet retail stocks like Amazon.com (AMZN) have also been boosted by the bull market in much of the tech sector. This stock also has been on a tear over the past few years and is currently trading at roughly 200 times our 2014 share-earnings estimate.

A very simplistic view maintains that all stocks will eventually return to more historically normal P/E ratios and levels of earnings growth. For example, the Dogs of the Dow approach suggests simply buying recent market laggards in the hopes that they catch up to their peers. From this perspective, the above stocks are overvalued.

We now turn to stocks that may be undervalued, using the same approach. But this view could be too simplistic. Although several stocks have higher earnings yields than the market average, most of the industries with low market valuations have cause for concern, which we discuss in more detail below and financial services stocks, which took much of the brunt of the financial crisis, continue to trade at low P/E ratios. This is likely due to the fact that some of these companies are still unwinding toxic assets that they built up during the years of the housing bubble and are dealing with higher regulatory costs. While our analysts look for considerable price recoveries for a good deal of these stocks, they still warn of various potential threats, and the companies will probably still be far from the strength of their pre-recession heydays from a profitability standpoint. Citigroup (C) stock serves as a good example here. The stock has been recovering gradually since the financial crisis, but is still several times below where it was trading at its pre-crash heights—adjusted for a reverse split.

Oil and gas stocks also look relatively cheap. This is a result of a glut of cheap oil and natural gas that has been produced by an unconventional drilling boom in the continental United States. This has caused the price of oil of to drop considerably. And it seems investors are factoring in lower prices in current stock valuations. Exxon Mobil (XOM - Free Exxon Mobil Stock Report) stock, for example, has been largely stagnant in recent years, as compared to the broader market. Steady dividend payouts have helped to close this gap in regard to total returns.

Tobacco companies like Philip Morris International (PM) are suffering from softening demand for traditional products and regulatory moves across the world. Concurrently, dividend yields and earnings multiples look pretty attractive in this area.

All told, we see a considerable divergence in the valuations of new technology stocks and some older mainstays. As long-term value investors look to rebalance their portfolios this year, perhaps to a more defensive stance, they may wish to consider industry outlooks and relative valuations like those outlined above. Our individual industry and company pages in The Value Line Investment Survey, offer up-to-date information on both present valuations and the respective outlooks for a number of undervalued issues.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.